Educational Articles

Using the Value Line Page: Hewlett-Packard and IBM - January 7, 2011

Reuben Gregg Brewer
| January 07, 2011

A quick look at the Graph section of their respective Value Line reports shows that the price charts for Hewlett-Packard (HPQ – Free Analyst Research Report) and International Business Machines (IBM – Free Analyst Research Report) are very different. In the case of IBM, the graph heads largely up since bottoming during the recession, denoted by a gray bar on the chart. HP, on the other hand, bottomed out, rallied until early 2010 and has fallen since that point.

In fact, a quick review of “% Tot. Return” box at the bottom right of the Graphs for each company quickly highlights the difference—IBM stock advanced over 14% in the trailing year through November 30th,while HP shares fell by nearly 14%. The trailing three-year figures are even more striking, with HP shares down about 16% and IBM stock up more than 40%.

Despite these divergent price paths, both companies have Above Average Timeliness Ranks, as can be seen in the Ranks box at the top left of their Value Line research reports. At first these ranks would seem inconsistent with recent price performance. However, it is important to remember that the stock market is a voting machine, but the Value Line Ranking System is a mathematical model that uses actual results to help predict future performance. That isn’t to say that the sometimes emotional swings of the market or the Timeliness Ranking System is “right”, only to say that one tends to be a bit more objective than the other.

From a purely statistical point of view, HP and IBM are very similar companies with roughly comparable operating performances of late. As the historical portion of the Statistical Arrayshows, both companies weathered the recession reasonably well, though IBM was able to post higher earnings throughout, while HP’s results dipped in 2009 and then rebounded nicely in 2010. Both companies, however, posted sales declines. The slight variation here is partly attributable to IBM’s shift away from hardware and toward services. The similarly strong earnings results of late, however, are what underpin the Above Average Timeliness Ranks for each company.

Looking toward future results, earnings and revenue growth expectations are roughly similar as well, as a comparison of the Annual Rates boxes of each company shows. Analyst Theresa Brophy, who covers both companies, expects Hewlett-Packard’s revenues to advance by an average of 10% per year over the next three to five years, with earnings increasing at about the same rate. Her projections for IBM over the same period are for annualized revenue growth of 6.5% and earnings growth of 13%. Much of the difference, again, can be attributed to their distinctive business models, with HP’s being more exposed to the lower margined business of creating and selling hardware. Still, the differences aren’t so large as to make one a materially better near-term investment candidate than the other.

Interestingly, the price advance that IBM’s shares have seen has created a materially different 3- to 5-year share price appreciation projection than that of HP. As the Projections box to the left of the Graph clearly shows, IBM’s earnings advances over the three- to five-year period suggest a share price gain of between 35% and 65% over the span. The stock’s recent runup has, thus, discounted some of its long-term appreciation potential. Hewlett-Packard’s weak recent performance, on the other hand, combined with solid long-term earnings prospects, leads to an expected 3- to 5-year share price gain of between 100% and 135%. Factoring in IBM’s dividend, which makes its shares yield more than double HP’s, only brings IBM’s total return projection (which is a combination of share price movement and dividends) to a range of 9% to 15% on an annualized basis. HP, meanwhile, has a projected total return range of 20% to 25%. Clearly, Hewlett-Packard stands out for projected price appreciation potential.

Looking at valuation, a quick review of the Top Label of each company’s Value Line report shows that each company is trading at a price to earnings ratio that is well below that of the broader market. HP’s relative valuation, however, is about 20% lower than IBM’s. Although the Statistical Array shows that the companies have traded at relative valuation above and below each other, the general trend has been for HP to be valued more richly than IBM. Thus, the current difference is something of an anomaly. The inevitable question is “Why do such similar companies have such different valuations right now?”

The emotional aspect of the market is likely to blame. While IBM is simply doing what it has always done, some fairly large issues surround Hewlett-Packard’s business. First, HP has been on a somewhat aggressive acquisition spree, with the integration of PALM leading the current list of concerns here. Second, the scandal surrounding former Chief Executive Officer Mark Hurd still lingers in investors’ minds—as should any event that leads to the resignation of a CEO. The unfortunate fact is that the event could still have lingering consequences for HP. Lastly, the new CEO, Leo Apotheker, is a technology expert, but not one directly from the hardware arena—which is still an important part of Hewlett-Packard’s business. Although he has yet to make material changes in the company’s direction, there is still likely to be some skepticism until he proves himself at HP. This is a material issue in that Hewlett-Packard has a very well-defined operating environment and corporate culture into which Apotheker must assimilate.

These aren’t trivial concerns, but do they merit such a disparity in valuation for companies that have such similar profiles? At the end of the day, the decision is up to the individual examining the companies. However, if taking on a little risk isn’t an issue, Hewlett-Packard shares appear to have the more compelling profit and appreciation potential at their current price.

At the time of this article's writing, the author did not have positions in any of the companies mentioned.